The Buffett indicator is a simple formula that, you guessed it, Warren Buffett created, to determine just how overvalued the stock market is.

Formula:

Total Market Capitalization / GDP

It’s actually well past ‘significantly overvalued’, think of the speedometer on your car jammed against 160 because it doesn’t go any higher, but you’re driving 220.

This weeks Feynman’s Finance explains the foundations of the Buffet indicator, and why it’s such a reliable measure of value.

It has never been higher in history, and sits well above ‘Significantly Overvalued’.

Consequently, Buffett and Berkshire are sitting on a lot of cash.

$344 Billion, the most they’ve ever held. And more than Apple, Microsoft, Google, Amazon, and NVIDIA combined.

The last time they sat on record cash?

Ahead of and during the 2008 financial crisis.

Having an ample “war chest” is a core part of Berkshire’s strategy, and has allowed them to make highly profitable investments while everyone else is freaking out. A few of their greatest hits from that cycle:

Goldman Sachs: $5 billion investment at 10% annual dividend + warrants → $3.7 billion profit

Bank of America: $5 billion investment at 6% dividend + warrants → $17 billion profit (his most profitable investment ever)

General Electric: $3 billion at 10% dividend → $1.2 billion profit

‘During the 2008 panic, Berkshire generated cash from operations and did not rely in any manner on commercial paper, bank lines or debt markets. We did not predict the time of an economic paralysis but we were always prepared for one.’

I feel like I heard this somewhere recently…

Despite worries over bad loans at midsize US banks, Moody's Ratings finds little evidence of a systemic problem, according to a CNBC report.

Marc Pinto, the agency's head of global private credit, acknowledged concerns over loose lending standards in an interview on CNBC's "Squawk Box." He noted some slack in the conditions that institutions attach to loans.

The worries stem from real losses. Zions Bancorp and Western Alliance Bancorp disclosed holding bad loans related to bankruptcies of two auto lenders. Investment bank Jefferies took exposure from bankrupt auto parts maker First Brands.

Meanwhile, auto loan delinquencies just hit all-time highs. Subprime borrowers are defaulting at 6.6%—the highest rate since tracking began in 1994. Even overall delinquencies exceed 2009 crisis levels.

On JPMorgan's recent earnings call, CEO Jamie Dimon raised eyebrows when he said: "When you see one cockroach, there are probably more."

Marc Pinto's response? "One cockroach does not a trend make."

AKA, everything is fine!

As you may recall, Moody's was one of the ratings agencies that “mis-rated” the dangerous investment products that led to the 2008 financial crisis.

By 2010, Moody's had downgraded 73% of its AAA-rated mortgage securities to junk status—roughly 3 out of every 4. For context, AAA is a higher rating than current US government debt receives, which investors consider bulletproof.

Ratings agencies make money with an "issuer-pay model." In short: banks paid rating agencies for ratings. If one agency didn't give them the rating they wanted, banks simply went to another one (Standard & Poor's, Fitch, etc.).

This is the equivalent of paying the salary of the teacher who grades your papers.

Surprisingly, this "issuer-pay model" didn't change after the '08 financial crisis. Today, Moody's ratings business generates approximately $4 billion annually—over half of the company's $7.3 billion in total revenue.

If I'm paying my teacher $4 billion a year, I’m expecting an A+, on a solid gold report card.

Ever hear or say, “I got a great deal on that [car, house, lawnmower, vasectomy]”?

What do we mean when we say that?

That the price we paid for that thing was less than it’s actual value.

Intrinsic value is just another way of saying actual value.

In his owners manual Buffett uses the example of a college education,

You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value.

First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

This simple formula has reliably predicted every major market crash in recent history. But why? After reading, you’ll understand total market capitalization, GDP and how they relate. And you’ll have a surefire conversation starter ready for holiday party season.[Read the full breakdown →]

Two of my favorite thinkers, from completely different spheres, share a remarkably similar perspective on debt, freedom, and peace of mind.

In 1996, Buffett issued An Owner's Manual to Berkshire shareholders explaining the company's operating principles. Principle #7 explains his $344 Billion rainy day fund.

We use debt sparingly. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results. But it is the only behavior that keeps us comfortable, considering our fiduciary obligations to policyholders, lenders, and the many equity holders who have committed unusually large portions of their net worth to our care. As one Indianapolis 500 winner said: 'To finish first, you must first finish.'

The financial calculus that Charlie and I employ would never permit our trading a good night's sleep for a shot at a few extra percentage points of return. I've never believed in risking what my family and friends have and need in order to pursue what they don't have and don't need.

As I detailed last week, much of this stock market bubble is driven by companies borrowing at record levels to support growth they can't sustain organically.

Dallas Willard, writing from an entirely different tradition, arrived at the same conclusion: "In our current world, a large part of the freedom that comes from frugality is freedom from the spiritual bondage caused by financial debt. People often incur this kind of debt by buying things that are far from necessary, and it diminishes our sense of self-worth, dims our hope for the future, and eliminates our sensitivity to the needs of others."

What Buffett describes as preserving a good night's sleep and what Willard calls freedom from spiritual bondage are the same thing: the ability to act from strength rather than desperation. Buffett's $344 billion in cash represents both the financial freedom to wait for real value and the psychological freedom to ignore the crowd.

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